A much-changed landscape for QDII

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The initial success of the QDII program exceeded the most optimistic expectations, with several funds raising more than 200% of their available quotas forcing regulators to increase allocations in an effort to satisfy domestic investor demand.

Eighteen months later we find ourselves in a very different economic environment. Fund managers around the world are recovering from the worst global market declines since the Great Depression, and in step with almost all global retail funds, China’s QDII funds hit the economic headwinds head-on. In the early part of the year over half of China’s QDII funds reported NAV losses in excess of 50%, with banks, domestic fund managers, and foreign fund manager products all recording dismal results.

Following the resurgence of global, and in particular Asian markets during the second half of 2009, Chinese institutional fund managers and banks have begun to submit fund product profiles to the Chinese securities regulator in anticipation of a new round of QDII quotas to be released by the State Administration of Foreign Exchange (‘SAFE”). Although the exact timing of any quota release is unknown, a review of the state of the QDII market is warranted, reflecting on previous experiences and considering opportunities as they relate to this important market segment.

Attitudes towards the QDII program remain optimistic but there is certainly no expectation of a windfall of investor cash chasing new QDII funds. Interest and capital commitments will likely remain conservative, and no fund managers indicate they expect retail interest to exceed available quotas. While retail interest may be more subdued than it was in the past, it is also interesting to note that fund managers are now able to utilize some of their QDII quota for discretionary fund accounts, encompassing private funds operated on behalf of high net worth investors as well as Chinese corporate clients looking to diversify their investment portfolios outside of China. These discretionary accounts may very well be the most interesting dynamic within the QDII program since its inception, providing banks and financial services firms with the ability to create corporate and private wealth management platforms on a global scale.

The second major shift within the QDII market is the move towards index funds and ETFs, a significant shift away from the actively managed fund profile prevalent in the intial rounds of QDII. Product designers now have a few years of QDII experience to draw upon, and funds replicating or tracking well known benchmarks have appeal to retail investors who can invest in known benchmarks without requiring knowledge of the underlying holdings. Competitive advantage will certainly go to those institutions that secure highly visible global benchmarks from providers who agree to domestic marketing rights to the underlying indexes. Benchmark trackers are also cheaper to manage than active funds and do not require a third party foreign fund manager to provide investment advice - cost savings that Chinese retail investors will certainly applaud. Lofty investment management fees will not resonate well with retail clients who are still recovering from their original QDII fund losses.

The final question that needs review is the timing of the next quota release, a subject that regulators are declining to discuss with the more than thirty fund managers who have QDII product and quota applications in place at the current time. Estimates range between Q4, 2009 and Q1, 2010 as the most likely date range, but this can change if regulators believe that the global investment climate will not be supportive of an influx of new QDII funds. Chinese investors will need to see some positive returns on this, the third round of QDIIs, if the retail market is to believe in the long term viability of the program.